As tax time approaches, we reach out to many clients who recommend they make annual contributions to a tax-advantaged retirement account. Saving for retirement – or whatever the next phase of life – is generally the most important long-term goal for any investor. It takes discipline and commitment to accumulate the necessary savings for a comfortable and enjoyable retirement lifestyle.
Today, we’re also intrigued to help clients with an even more surprising challenge- How do you manage your taxes when you’ve done too good a job saving in a tax-advantaged retirement account?
The 401K was launched in 1978 to complement and eventually replace the traditional workplace pension. Many young workers heed the best advice and work regularly to make the maximum contribution possible, reducing current taxable income and saving for the future. The magic of compounding and some very long bull markets have helped many people accumulate large and thriving retirement accounts in their 50s. It’s easy to think, “I’ve done everything right and I can see this account growing over the years.” However, that may not be the best approach.
The challenge is that traditional 401K plans and traditional IRAs require withdrawals starting at age 70 ½, and these withdrawals are taxed as ordinary income – both the deposits you make and capital growth. This works well if you find yourself in a low tax bracket in your retirement. However, many successful savers today are forced to make the necessary large withdrawals in their 70s so they find themselves paying high income taxes well into later years.
In contrast, a Roth IRA only accepts after-tax contributions, but no withdrawals are ever required. In addition, after the age of 59 1/2 all withdrawals that meet certain requirements are completely tax-free – both after-tax deposits and growth.
What can you do to celebrate the big savings you’ve racked up in that IRA or 401K, and still make some smart decisions to limit your future tax liability? Here are 4 steps to get started now to help avoid high income taxes later:
- Make a Roth IRA contribution annually. If your annual income qualifies, you must make contributions to a Roth IRA. This year, the limit is $6,000 per person and $7,000 for those over 50. If your income exceeds the limit, you may be able to make “backdoor” contributions by making your deposit into a traditional IRA and then converting it into a Roth IRA.
- Switch to Roth 401k contributions instead of traditional workplace contributions. Your Roth 401K is funded with after-tax contributions. That means they will no longer deduct your income reported on your W2 each year, but now these funds will increase tax-deferred and when you leave your employer you can put it directly into a Roth IRA. Then you can choose to withdraw the funds completely tax free when needed, or leave the funds untouched in the account, to grow for your heirs.
- Change to a traditional IRA in low income years. If you’ve stopped working or had a year of very low taxable income, it may be a good time to convert some or all of your traditional IRA to a Roth IRA. You will pay ordinary income tax on any amount in a traditional IRA that you convert to a Roth IRA.
- Take a distribution or make a partial IRA conversion. Even if you’re in a high tax bracket, if you have a very large IRA today and you’re over 59 1/2, you might consider taking small distributions each year starting early. Ask your accountant about how much you can withdraw (or convert) without pushing you into a new tax bracket. Sometimes, you can even make small withdrawals/conversions with little or no additional taxes for the year. This small amount can add up over time and help reduce future taxes.
Who would have thought you could “win the retirement game” but lose it all on taxes? When 401ks first launched, everyone envisioned a structure that could encourage savings and offer a source of income later when one’s taxes would be lower. Right now, few of us expect that US tax rates will be lower in the coming years. If you’ve made significant savings on your corporate retirement plan or traditional IRA, you may now realize that you could be forced to withdraw hundreds of thousands per year one day – at the same or higher tax rate than you might be paying today. . Consider these steps you can start now to manage your taxes in the future.